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Correction to This Article
A photo caption with the column incorrectly described a protester outside Romania's presidential palace in Bucharest as Hungarian. The protester was Romanian.

U.S. suffers from same afflictions now causing turmoil in Europe

European finance ministers including Spain's Elena Salgado bought some time with a rescue package, but the real problem is underlying.
European finance ministers including Spain's Elena Salgado bought some time with a rescue package, but the real problem is underlying. (Jock Fistick/bloomberg News)

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By Steven Pearlstein
Wednesday, May 19, 2010

There are several reasons why Americans should care about Europe's unfolding debt and currency crisis.

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The most obvious, of course, is that it continues to be very unsettling to financial markets. Two years ago, it was turmoil in the United States that spread to markets elsewhere and eventually triggered a global recession. There is no reason to think that Europe's kind of financial contagion cannot spread just as easily, setting off an economic aftershock that could rattle more than just a few windows on Wall Street and Main Street.

The financial linkages to the United States from the Club Med countries run through the banking systems of France, Germany, Switzerland and Britain. And it's not just the sovereign debt we have to worry about -- there's also the short-term bank debt, the credit-default swaps and the currency swaps. It's also worth remembering that Europe's economy is just as big as ours and even more dependent on global trade. If Europe is going to dip back into recession, as many now expect, that carries negative implications for economic growth just about everywhere.

Then there is the small matter of the free fall of the euro. A euro trading at $1.20 may finally make it possible to take that dream trip to Mykonos, but it also will make it that much harder for U.S. exporters to compete with European companies -- not just in European markets but in the booming economies of Asia and South America as well. For a country such as ours that needs desperately to export more and import less, an appreciating currency is not exactly a step in the right direction. Aside from these direct and indirect effects, however, the biggest reason we should care about the European crisis is because of what it implies about our own economic recovery.

Despite much of what has been written, Europe's fundamental problem is not that the governments on its periphery have been living beyond their means. That may be true for Greece and Portugal, but it was not the big problem in Spain or Ireland -- at least not before the bursting of gigantic housing bubbles that sent unemployment rates soaring and tax revenue into a steep decline.

The more basic problem is with the euro itself. After a decade of experimentation, what Europeans are discovering is how difficult it is for countries with widely varying income levels, widely varying productivity growth and closed labor markets to all share the same currency.

Currencies, it turns out, are wonderful adjustment mechanisms. They make it easy for countries to continue to do business with each other even as they experience different growth rates or prices, or changes in productivity. But when countries adopt the same currency and give up this adjustment mechanism, there tends to be mispricing of wages, products and financial risk.

In time, some economies, such as Greece, have become uncompetitive while others, such as Germany, have become hypercompetitive. And because there is no flexibility in the exchange rate, large imbalances begin to develop between them -- imbalances in the flow of goods and services and capital. These disparities have now grown so large that the entire euro project is in jeopardy.

The problem with the trillion-dollar rescue package announced last week is that it does not solve these fundamental problems but merely postpones the day of reckoning. At this point, it is almost inevitable that a country like Greece will be forced to default on its debt unless it is willing to put itself through a grinding process of reducing wages and prices on the order of 20 percent -- and even then, there is a good chance it will be so dragged down by depression and deflation that it will be unable to service its debt anyway. At that point, the only way to avoid default will be if German, French and Dutch taxpayers are willing to step in to pay off a large portion of the debt of their less-productive neighbors.

The moral we should draw from this European story is that while government rescues may be necessary to stabilize markets, there can be no real recovery until the causes of the underlying imbalances are dealt with. For the United States, those root causes are an overvalued currency and a penchant for living beyond our means by consuming more than we produce.

Over the past two years, households and businesses and financial institutions have done a valiant job of reducing the debt on their balance sheets, but the only reason they were able to do so was that the government was willing to artificially pump up the economy by injecting what amounted to $3 trillion in fiscal and monetary stimulus. By substituting public debt for private debt, we managed to delay the day of reckoning.

At some point, however, the piper must be paid and the system put back into balance. Europe is now embarked on its version of that rebalancing, which is likely to involve debt restructuring and as well as some members' noisy exits from the euro zone. And before long, we in the United States will go through our own adjustments as the Federal Reserve moves to sop up all that cheap credit it injected into the financial system, as the nation's trade accounts are put into balance and as the federal budget deficit is brought under control.

The lesson from Europe is that it is better to tackle these adjustments sooner rather than later so they can be done on our terms rather than those imposed upon us by financial markets.


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